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Connecticut College

. James Henry has followed competitive local exchange carriers and Internet service providers at

Bear Stearns

since 1997. Before that, he was a telecommunications analyst at

Deutsche Bank

for three years.

Industry Outlook and Style

These days, investors might be tempted to run from each and every competitive local exchange carrier, or CLEC, given that CLEC stocks have on average fallen 55% since January.

That would be the wrong move, according to James Henry. "Don't interpret this year's shakeout as damning the CLEC opportunity," insists the Bear Stearns analyst, who has followed CLECs since the industry's inception in 1994 and currently tracks 20 companies. "It's still a very appealing market, though it's more critical than ever to bet on the right companies in this space," he says.

Think of the positives this way, Henry urges: "The local telecom market -- $110 billion in size -- is the largest and most profitable segment of the entire industry. The RBOCs (regional bell operating companies) still own 95% of the local market, so the opportunity for new entrants -- the CLECs -- to take substantial share from the incumbents is huge."

At the same time, Henry warns, one should be highly selective in choosing which CLECs to invest in. "We envision the shakeout continuing for another two years," he asserts. Of the 45 publicly traded CLECs, he figures that fully half of them will disappear, either by consolidation or Chapter 11.

The surviving players will benefit from the shakeout, since they'll have "the same great market opportunity" but less competition in their bid for a large share of it, Henry believes. "And they'll be able to acquire attractive assets at very reasonable prices," he adds.

But while this weeding-out process may ultimately be good for the industry, it can make investing treacherous. How to know whether a company is a potential landmine?

After so many CLECs stumbled and missed their numbers in the second quarter, Henry developed a "soft spot" analysis, which he describes as "a tool that allows investors to draw objective conclusions as to which companies will be the winners and which will be the losers." They analyzed the level of exposure that the 35 leading public CLECs have to declining long-distance business and the interconnection fees each carrier must settle with competitors. "Excessive or unpalatable exposure to these elements caused companies to miss their expectations," he notes.

As with any industry, Henry advocates that investors in the CLEC sector buy companies with strong managements, healthy balance sheets, good financial and operational performance and strategic relationships. More specific to CLECs, however, the Bear analyst advises investing in a basket of stocks.

Dispersing assets among several companies is the least risky and most rewarding strategy, he notes. In early September, he added two names to his basket of must-own stocks. One is

Allegiance Telecom

( ALGX), the other

XO Communications



Nextlink Communications

). He also endorses

Time Warner Telecom



McLeod USA

( MCLD), which have been on his buy list since January. (Bear Stearns has served each in some investment banking capacity over the past three years -- either advising strategically or raising debt or equity.)

XO Communications is Henry's top stock pick. He describes it as "the archetype to which other CLECs and telecom service providers should aspire." XO has a "best-in-class product portfolio," he says, mentioning its bundle of local, long-distance, Internet and enhanced-data services. It also has a "best-in-class network infrastructure," he contends, with local fiber-optic networks in the top 60 U.S. markets and in five of the largest European cities. What makes the company unique is that it provides all three types of lines -- fiber-optic, fixed wireless and digital subscriber line, or DSL -- whereas its competitors offer just one or two types.

Allegiance, another of Henry's favorite names in this sector, offers telecom service principally to small and midsize businesses in the top 36 U.S. markets. Henry cites several reasons to like the company: It's run by a strong, seasoned team of industry veterans, it has consistently delivered financial and operational performance exceeding Street expectations, and it is fully funded for its business plan.

As for Time Warner Telecom, it benefits from having a giant of a parent. This gives the company access to capital and also the ability to build extensive fiber-optic networks at a low cost by sharing rights of way with Time Warner's cable company.

Stock Pick

Favorite stock for next 12 months:

XO Communications; price target: $50


"We're saying XO will post year 2000 revenue of $700 million and year 2001 revenue of $1.5 billion. Along with Time Warner Telecom, McLeod USA and Allegiance, XO is among the best-capitalized and best-managed CLECs. All of them are well-positioned to create shareholder value."

Rate Their Stock Picks:

Which stock do you like best?

Henry: XO Communications

Kastan: McLeod USA

Kennedy: Time Warner Telecom

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